De-risking and future-proofing commercial leases

As the workforce recovers from the impacts of 2020 and more people realise the productivity and lifestyle benefits of working away from traditional offices, commercial tenants are increasingly rethinking their future space requirements. 

De-risking and future-proofing commercial spaces – having regard to both the physical environment and how offices can be used to drive workplace strategy – will be front of mind for many, as will making offices places to collaborate, innovate, problem-solve, connect and socialise, in line with shifting culture expectations.  

The Sydney Morning Herald reported in July 2021 that 42 of Australia’s 50 biggest companies have permanently adopted hybrid working arrangements for office-based employees, with a further six companies planning to implement flexible working policies where appropriate. A survey conducted by PWC in February 2021 revealed that a hybrid working environment is preferred by 60% of Australian workers. 

Simple lease renewals and conventional fitouts are giving way to deals involving increased space flexibility, utilisation of versatile co-working or ‘third’ spaces in buildings and adaptability in fitout design and delivery. Tenants are achieving their post-COVID strategic planning requirements through either sourcing new space where they can start with a clean slate, or ‘staying put’ but collaborating with their landlords to bring forward lease negotiations, enabling them to right-size their space and fitout requirements, frequently in return for an extended lease term.

Versatile co-working spaces on the rise

Commercial tenants are increasingly realising the benefits of versatile co-working spaces, also known as ‘third’ or ‘flex’ spaces. For landlords, having a dedicated co-working space in a building will only be commercially viable where there is significant tenant take up. The availability of co-working spaces in a building may influence the core leased office space required by a tenant, with critical considerations including:

• the types and suitability of co-working spaces available (for example, boardrooms, lounges and extra desks for use during peak periods);
  
  
• whether the spaces are exclusively reserved or prioritised for tenants of the building;
  
  
• whether the spaces are operated by the landlord, developer or a co-working provider; and
  
  
• the financial terms of use.

Co-working spaces are emerging as a key building amenity and office space differentiator. They provide a valuable form of office ‘placemaking’ by providing a space that enhances wellbeing and productivity and brings together a broader community of businesses. 

In the wake of the pandemic, more organisations will be looking to de-risk and rethink how they use office space by leasing and fitting out the organisation’s core space while utilising these collective spaces on an as needs basis, as an alternative to or in conjunction with incorporating expansion and contraction flexibility into leases. 

Space flexibility will guide deals

As hybrid working and the growth of collective spaces in buildings paves the way for the potential to change space requirements, commercial tenants are seeing the need to incorporate space flexibility into their leasing deals. Some key mechanisms through which commercial tenants may implement space flexibility include:

1. Planning and starting early. A lease renewal or search for new premises should commence well ahead of the tenant’s lease expiry. The tenant’s ability to negotiate better outcomes will be enhanced by the tenant determining its needs and requirements early. Owners are better placed to accommodate expansion and contraction rights and rights of first refusal for anchor tenants or tenants that are engaged in early pre-commitment deals. Tenants will of course need to find a balance between going to market early and the risk that early market engagement will require a tenant to, absent a flexible arrangement, prematurely ‘lock in’ its requirements.
   
   

2. Expansion and contraction rights. Expansion and contraction rights allow tenants to change their leased area due to evolving business needs. These rights are negotiated by tenants who anticipate changes in their future office space requirements, with key considerations being:
   
   

• the ability of the landlord to lease expansion space when not used by the tenant;
  
  

• when the right may be exercised and the length of notice;
  
  

• the condition of the premises and status of fitout;
  
  

• the amount of additional or reduced rent and incentive; and
  
  

• other higher ranking expansion rights granted by the landlord.
  
  

3. Rights of first refusal. Rights of first refusal are a feature of larger leases and they compel a landlord to offer a lease to a tenant before leasing available space. There are myriad ways to structure rights of refusal. Ideally the lease terms would align with the tenant’s existing lease, although the commercial terms such as the rent would be at market rates at the time. 

Space flexibility comes at a cost, as landlords need sufficient certainty to lease the balance of their buildings. Tenants will need to plan their space requirements carefully by reference to their organisation’s unique hybrid working behaviours. 

Greater adaptability in fitout design and delivery

Greater adaptability in fitout design and delivery are anticipated to become a feature in post-COVID builds to accommodate last minute modifications consequential on rapidly changing local conditions. This may lead to fewer integrated fitouts, as tenants seek to separate their ever-changing space requirements from base building specifications. 

In the immediate future, developers may also seek to negotiate additional contingencies in anticipation of future COVID outbreaks. A further challenge arises in the context of regulatory and legislative change in relation to density and social distancing requirements. 

The need for flexibility will impact on both the scope and nature of the works, and the delivery model / contract form. Adaptable fitout delivery and design is likely to require or allow for:

• fewer fixed walls to allow spaces to be reconfigured;
  
  
• flexible proportions of office, co-working, quiet and client engagement spaces;
  
  
• fewer features impacting the base build (for example, voids);
  
  
• minimum technology requirements to facilitate connection with remote workers;
  
  
• prioritising occupant health in fitout design by creating well-ventilated, natural light-permeated and green office spaces with enhanced hygiene measures; and
  
  
• prioritising wellbeing facilities such as gyms, cafes, retail and end of trip facilities.

Fitout contracts will need to contain robust and carefully considered variation provisions to enable reconfiguration of design to adapt to changing circumstances, with close attention being paid to building in (and fixing) time and cost contingencies. 

Tenants may seek closer involvement in, and more control over design outcomes, trade contractor selection and (to protect against insolvency risk) direct avenues of recourse to suppliers and subcontractors. Design and construct, which for many tenants is procured on a ‘set and forget’ basis, may give way to different structures, in particular managing contractors with a guaranteed maximum price, and tenants who want complete control may engage in construction management.